Warren Buffett's Approach to Investing
By Dale Gillham | Last Updated 13 January 2020
Warren Buffett, also known as the Oracle from Omaha, is arguably the greatest investor of all time. Warren Buffett is the CEO and largest shareholder of Berkshire Hathaway who has amassed an astonishing net wealth of US$88.9 billion, making him the fourth wealthiest person in the world as of December 2019. Therefore, it comes as no surprise why his approach to investing has become so popular.
So how does Warren Buffet invest and why is he so successful? What follows are eight investing principles that Buffett implements in his approach to identifying and investing in companies. In discussing these principles, I will also provide my perspective on why I believe some of these may or may not be as relevant when trading in today's environment.
1. Long term value investing
Warren Buffett's strategy is based on long term value investing passed down from his mentor Benjamin Graham. According to Benjamin Graham, long term value investing involves purchasing stocks at prices below their intrinsic value and then holding on to them until their price reflects the real value of a company.
Therefore, according to Buffett, the secret to getting better returns is to buy a stock and forget about it, which is referred to in the financial services industry as the buy and hold mentality. In his view, constantly buying and selling stocks will erode a significant percentage of your investment returns in the form of commissions and taxes.
But I would challenge Buffett on this way of thinking, particularly given that the cost of buying and selling stocks these days is pretty much insignificant in comparison to the amount of capital loss you will sustain by buying and holding onto falling stocks. In fact, the mentality of buy and hold does not allow you to compound your returns by buying low and selling high.
Even after factoring in capital gains tax and brokerage, you will still be far better off exiting from an asset that is falling in value. You will have retained all of your original capital investment plus any potential gain you made, which will enable you to invest in another stock that is rising, meaning your portfolio will compound more rapidly.
Given this, based on my experience, you will achieve far better returns by timing the market than you will spending time in the market.
2. Over-diversification is not a good idea
While most knowledgeable investors understand the importance of diversification, unfortunately many investment managers push the theory of over-diversification, which tends to increase their bottom line, not yours.
Consequently, many investors over-diversify their portfolio because they are afraid that any one stock may sink their entire portfolio. But as Buffett eludes to, over-diversification is for people who do not understand much about investing. In fact, over-diversification will condemn you to investing mediocrity. Let me explain.
While the concept of diversification was designed as a way to reduce volatility within a portfolio, what I have discovered is that over-diversification actually reduces your returns because you are exposed almost exclusively to market risk, which cannot be eliminated by diversification.
Based on my experience of investing over the past 30 years, a well-diversified portfolio should only hold between 5 and 12 stocks, as this will allow you to maximize your returns while minimizing your risk. Because if you think about it, you don’t get twice the benefit from holding 20 stocks than you do from holding 10, and you certainly don’t get 10 times the benefit from holding 100 rather than 10.
3. Invest in yourself first
According to Buffett “the best investment you can make is in your own abilities. Anything you can do to develop your own abilities is likely to be more productive…" which I totally agree with.
Buffett also states that the one of the biggest challenges when it comes to investing in the stock market is failing to trust your investment decisions, which often stems from a lack of knowledge or expertise about the risks you are taking.
Given this, it makes sense to invest in yourself first by gaining a proper trading education that will ensure you are successful over the long term? Why waste valuable time hoping to win, when you can invest with knowledge knowing you are going to win more times than you lose.
Unfortunately, too many do the opposite of what Buffett advocates by making themselves dependent on others, such as brokers, stock reports and tips from friends and family, to name a few. In fact, if you continue to rely on others to tell you what to invest in, you will continue to subject yourself to emotional decision making, which is not a very effective way to succeed in the stock market.
But if you invest in yourself, you will gain the knowledge to overcome the fear. Indeed, the fear of failure or the fear of being wrong is so easily overcome by acquiring the correct knowledge that will enable you to build sustainable long term wealth.
4. Buy quality companies
As we eluded to earlier Buffet believes in investing in quality companies, as he would rather pay a fair price for a great company than a low price for a mediocre company.
But the appetite for investing in quality blue chip stocks has diminished, with many investors favouring the perceived value of investing in cheap small cap or penny dreadful stocks. This is based on the idea that if the market does pullback, then at current prices these stocks have the least to fall.
But this belief not only costs you money, it usually hinders your ability to generate profits because you are investing your faith in speculative stocks. In other words, you are speculating that a cheap stock will perform better than a solid blue chip stock.
In my experience, when investors buy cheap stocks trying to get a "good buy", they usually end up saying goodbye to their money, which explains why so many traders fail when trading the stock market.
Therefore, I totally agree with Buffett, as your aim should always be to buy quality stocks, not quantity, because this is where you will get the greatest gains.
5. Invest in companies and industries that you understand
While it makes sense to only invest in companies and industries that you understand, unfortunately too many people get caught up in the hype and speculation of certain investments, such as investing in cryptocurrencies. But Buffett cautions that you should never invest in assets that you do not fully understand, and I totally agree with him.
Before you invest, you need to understand how a company (or investment) works to make money, and the main drivers that impact the industry in which they operate. According to Buffett, if he cannot understand this in 10 minutes, he moves on to evaluate another investment on this basis.
When teaching traders and investors, one of my mantras is to always keep things simple, which is what I believe Buffet is saying. All too often, individuals invest in markets or companies they do not understand, which causes emotional decision making and poor returns.
If you don't possess the knowledge to understand how the market works or the risks of investing, you are better off sticking to the top 20 stocks in the market, as these represent the least amount of risk and will support you to build long term sustainable wealth.
6. Buying shares is buying a part of a business
Imagine you are buying an ownership stake in the convenience store around the corner from your house. You would automatically think about the competition, suppliers, prices, etc. You would also consider both the specific location of the store, as well as its competitive position in the market.
Similarly, when buying stocks, you need to be able to analyze this information using both technical and fundamental analysis to ensure you are investing in good quality companies that will rise over the medium to long term.
Unfortunately, too many people treat the stock market and, the buying and selling of shares, like a casino, whereby they tend to gamble with their money. This occurred during the tech wreck and other market booms and busts, where the masses invested in assets that had little or no intrinsic value or potential to profit.
However, with the right knowledge, you can avoid these costly mistakes and so that you protect your downside. In fact, as I outline in my latest award winning book, Accelerate Your Wealth, by taking a low risk, long term approach to trading the stock market, you can achieve better returns than the majority of professionals and pocket the fees you would otherwise pay to have someone else manage your money.
7. Manage your risk
According to Buffett, his number one rule is to never lose money. His second rule is to never forget rule number one. His other famous quote is to understand that risk comes from not knowing what you're doing.
The reality is that while the majority of people investing in the market understand how to manage risk on an intellectual level, very few are able to do it well. And that’s because more than 90 per cent of traders and investors don’t understand how to minimize their losses. In fact, many individuals know how to buy a stock but very few know how to sell and, consequently, end up losing their capital because they have failed to set a stop loss.
As Buffett states, when a company no longer fits his criteria, he sells. Therefore, I encourage you to resist the urge to make excuses to stay in an investment when the risk of holding it becomes too high. In fact, knowing when to sell your shares is critical to your longevity in the stock market.
8. Learn from your mistakes and move on
You might be surprised to learn that even Warren Buffett makes mistakes but he makes sure that he learns from his mistakes.
Buffett recommends keeping a record of the mistakes you have made so you know what went wrong to ensure you don't repeat the mistake again.
Documenting your mistakes is a way of taking responsibility for them because all too often we sweep these under the carpet, as if they never occurred. But being disciplined and accountable are both great traits of excellent traders.
Buffett goes on to say that you should share these lessons with your children and grandchildren, so they don’t go on to commit the same mistakes. I really appreciate Buffett for not only sharing his lessons with his family but also with the world and I hope you do too.